Essential Concepts in Pricing Loans
Between the end of 2016 and 2018, the Federal Reserve incrementally increased the target Fed Funds Rate eight times from 0.50% to 2.50%. During this period, community banks took advantage of this rising rate environment by increasing their Yield/Cost spread. Loan yields increased 45 basis points from 4.65% to 5.10%, while deposit costs only increased 30 basis points from 0.43% to 0.73%. Further, the increase in deposit costs lagged the increase in loan yields, providing further margin enhancement.
The Fed held its target rate steady for the first half of 2019 but have since dropped it 75 basis points to a range of 1.50% – 1.75%. During this time, the cost of deposits has continued to rise due to the lingering effects of high special CD offering rates and competition from public fund competitors.
Concurrently, loan yields began to decline in response to the drop in the Prime rate and continued competitive pressures. Many banks are reporting that they are seeing loosening credit standards and irrational pricing from their larger in-market competition.
So, what’s the best way to use your loan pricing software to respond to this current environment?
Keep your model calibrated
In a previous article , we explained proper target ROE calibration. This process will help you define clear “walk-away” points and how competitive you can be on individual loans and relationships.
The chart below shows the UST curve on 12/31/2018 and 10/31/2019. The curve remains relatively flat out until the 10-year point. Most banks are using a market-based curve like this as the “cost of funding” curve within their pricing software. If no adjustments are made, a flat curve causes extension risk. In other words, if your model suggests similar required yields for a 3-year, 5year, and 7-year fixed rate loan, then you aren’t being compensated for locking up funds for longer terms. By applying a liquidity premium that increases the farther you go out on the curve, your model will suggest appropriately higher required yields for longer terms.
Credit Based Pricing
Your model should adjust its pricing recommendations based on the credit grade of the borrower. For example, in the most basic configuration, your model should at least show a 4 rated credit pays a higher rate than a 3 rated credit. Also, your credit adjustment factors should begin to include the CECL impact of losses over the life of the loan.
Customer Relationship Profitability
Make sure you look at full relationship profitability within your pricing model. Often, low-cost, large balance deposits can reduce the required loan yield by 5 to 20 basis points.
Rate Floors and Prepayment Penalties
Use your model to calculate the impact of loan floors and prepayment penalties. If you aren’t doing so already, protect yourself from further declines in rates by putting floors and prepayment penalties in your new loan deals.
Contact us today to schedule a demo and learn how we are helping institutions every day improve their profitability.